Zombies in Paradise

Mauritius too has many more Zombie companies than we wish to admit. More worryingly, the growth in Zombie companies means low job creation, low investment and low growth for a long time to come

By Sameer Sharma

Over the past few months, businesses have been put under a large amount of stress to say the very least. The lockdown forced many companies to shut down and others to limit their operations. The tourism and leisure sector was perhaps the most affected. The significant drop in revenue forced many companies to take drastic measures which they would normally never take and that is why we are seeing the creation of a new phase of the economic crisis, a crisis which leads to slow and painful de-leveraging of corporate balance sheets and yes invariably a slower recovery to come.

Loose lending keeps Japan’s ‘zombies’ shambling along: Nikkei Asian Review. Photo – www.ft.com

In the early 1990s, Japan was a powerhouse. World War II had caused the destruction of 40% of Japan’s infrastructure but during the post-war recovery, the Japanese were able to rebuild their economy from scratch, investing in new and more efficient factories than those of the rest of the world for example which gave them an advantage compared to the global competition. Japan also underwent a period known as the “gifts from heaven” wherein Japan became a democracy, workers obtained labour rights, women obtained the right to vote, farmers were allowed to own their own land, and the ability to do business was liberalized. These factors when coupled with high levels of Japanese productivity turned Japan into an economic powerhouse.

Japan in the 1980s was viewed in the same way as we view the China of today. However, the 1980s also saw the Bank of Japan impose loan growth quotas, major adjustments to the exchange rate and various other factors which led to the creation of asset bubbles which all came back home to roost by the early 90s. In fact the stock market index has never recovered since 1989 in real terms. A large portion of Japanese companies which were loaded with debt could not on their own withstand a long period of low or negative growth and turned into Zombie companies.

What essentially happened was that large Japanese firms which were loaded up with debt had these restructured in such a way that they would only pay the bare minimum. Many kept on borrowing at lower rates in order to survive. In order to just get by, Japanese companies either had debt restructuring or got partial bailouts. The problem with the Zombie companies was that they were still too debt ridden to expand and recover. The companies were in essence Zombies and were only being kept alive with debt. Japan has never recovered since. (The paper “Zombie Lending and Depressed Restructuring in Japan” by Ricardo J. Caballero, Takeo Hoshi and Anil K. Kashyap led the way in focusing on the existence of these zombie companies as the cause behind the long-term stagnation of the Japanese economy.)

US Fed efforts could create more ‘zombie companies’: Deutsche Bank’s Slok. Photo – i.ytimg.com

In 2005, 2.5% of all companies in the US were defined as Zombie companies. Post the 2008 Great Financial Crisis, this figure began to increase and by 2019 it stood at 16%. Over the past two months alone, the figure has increased to 19%, a figure comparable to that of Japan in the 1990s. A long period of near zero interest rates may be to blame as companies continued to restructure and pile on debt. US companies have borrowed more than a trillion dollars of debt during this crisis, 9 times higher than usual. There should be no doubt that the growth outlook for this decade is not rosy.

Allowing Zombie companies to linger in fact may not be good for long term growth. The problem is that allowing these companies to die destroys jobs too and takes the economy into a sharper contraction in the short run. one can argue that, in the long term, this may bring more competition and a sharper recovery, but that assumes that we survive a social crisis. No one can wait for years. This is the dilemma we find ourselves in.

Large and mid-sized Mauritian non financial firms, especially those with large land banks have typically had closed all in the family capital structures on the equity front and have relied heavily on frequent asset revaluations and bank debt. A small and saturated market, an overly passive shareholder base and a Jack of all trades approach by some captains do not play well for Mauritius.

In recent years, large amounts of excess liquidity in the economy allowed some large firms to issue long term bonds at mispriced credit spreads. Credit ratings were also quite flattering and remain so today. Worse, an analysis of non financial firms with turnover above Rs 100 Million would showcase the fact that the return on capital employed of these companies are on average lower than their weighted average cost of capital and in some cases even the cost of debt. While too many tend to focus on net profits which are in any event not spectacular when you strip off financial companies in Mauritius, free cash flows tend to be quite poor while asset values tend to be too high. The less said about valuation standards and its functioning in Mauritius the better.

Mauritius too has many more Zombie companies than we wish to admit and this number is increasing. Some companies loaded with debt including structured notes and corporate bonds will see multiple covenant breaches and the reality is that no one really knows when a meaningful recovery will take place. Any changes in the payment cash flows of a bond is a soft default and should be treated as such. More worryingly, the growth in Zombie companies means low job creation, low investment and low growth for a long time to come.

In order to respond to the Zombie dilemma, many companies will need to be recapitalized and debt burdens reduced as long as they are deemed to hold promise on the viability front. Asset values just like they went up too much will need to be re-evaluated to more realistic levels based on fundamentals but that process will need to be gradual given the potential negative impact of steep valuation drops on the creditors.

The idea of creating a Central Bank funded special purpose vehicle (SPV) to re-capitalize viable firms will be politically difficult but necessary. The idea would be to engage in special situations investing and in many cases provide quasi equity funding in the form of convertible preferential shares and other funding to deemed viable firms allowing them to restructure themselves and become healthier and over time more performance driven. In such special situations, private equity players also negotiate heavily with banks for haircuts because they too must bare part of the responsibility.

Mauritian companies have relied too heavily on debt and have kept their capital too closed and this model will not work in the post-covid world. Should majority shareholders have money abroad, conditions should be imposed for them to bring their money back before any bailouts. The reality is that all sides will need to take some pain. The SPV will need to review its return targets to realistic levels because if they push for too many bank haircuts, then bank capital will be impacted, the banks in turn will need to accept some pain while the shareholders of distressed companies will need to inject more equity, become more performance driven or eventually accept equity dilutions. All the pain should not be borne by taxpayers but we do need to recognize and understand that allowing more Zombies to crop up is not a good end game for paradise.

* The paper “Zombie Lending and Depressed Restructuring in Japan” by Ricardo J. Caballero, Takeo Hoshi and Anil K. Kashyap led the way in focusing on the existence of these zombie companies as the cause behind the long-term stagnation of the Japanese economy

* Published in print edition on 30 June 2020

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